8. As the Personal Investment Authority (PIA), a
predecessor organisation of the FSA, warned some years ago, "compared
with an ordinary repayment mortgage, endowment-related mortgages
are complex products. They have features with which many borrowers
will be unfamiliarespecially the nature and extent of their
exposure to market risks."[6]
This view was reinforced by evidence the Committee heard from
independent experts, such as Professor Davis of Brunel University,
who argued that in reality there was a "fundamental problem"[7]
with endowment mortgages. The consumer is assuming a liability
which is both fixed in nominal terms and often very large relative
to his available assets. To pay off this liability the consumer
is investing in an endowment policy which is often largely invested
in equities, an asset class that is both volatile and exposed
to lower nominal returns as inflation falls. As Mr O'Brien of
Nottingham University Business School told us, "the problem
with endowment mortgages is you have this nominal liability and
it isn't going to be covered when you get disinflation."[8]
Set against these drawbacks were certain tax advantages in the
1970s and 1980s (discussed in paragraphs 13 and 14 below). While
the balance of risks and possible rewards offered by endowment
mortgages may have appealed to some individuals, the lack of certainty
that an endowment policy would be worth enough at maturity to
pay off the mortgage means that such mortgages were probably unsuitable
for many homebuyers.

9. Buying a home is the largest single financial
transaction most people undertake in their lives and the financial
services industry owes a particular duty of care to its customers
in the marketing and subsequent management of relatively complex
financial products such as endowment mortgages. Unfortunately,
the reality is that in selling low-cost endowment mortgages the
industry often failed to provide homeowners with a suitable product
for their individual circumstances or a product that was fit for
the purpose it was being used for. The performance of the financial
services industry in providing reliable and effective products
to those looking to fund a house purchase is likely to be crucial
in shaping consumers' views of the industry. The failures in respect
of endowment mortgage policies are a contributory factor towards
the low consumer confidence in the industry.

11. Some companies told us that with-profits policies
had a valuable role to play. Standard Life said that "we
remain committed to the with-profits concept because of its potential
to provide better performance than deposits without full exposure
to the volatility associated with longer term, equity-type investments."[11]
Independent experts and consumer groups have nevertheless typically
told us that there is a strong case for reform. The National Consumer
Council, for example, said that "Despite the well-documented
weaknesses of the with-profits model, we do consider that some
consumers might welcome a good value smoothed investment product
offering some long-term stock market exposure alongside limits
on volatility. But this requires greater transparency regarding
the basic product proposition, and a fairer deal in terms of charges."[12]
Mr Sandler told us that "I think a large part of the answer
for the insurance industry lies in the reform of with-profits,
which are in a sense the flagship product of the insurance industryless
so today than was the case even as recently as a few years ago
but, nonetheless, historically, the core savings product of the
insurance industry. That is a product which represents the extremes
of opacity, which has the extremes of complexity built into it,
and a very substantive process of reform in my judgment has to
be mandated on with-profits if we are going to get the sort of
functioning of the industry that we all, I believe, would wish
to see."[13]

12. The FSA has proposed reforms for with-profits
products in its consultation paper CP 207, commonly referred to
as "Principles and Practices of Financial Management".
The view of several experts we asked was nevertheless that the
FSA's proposals were unlikely to significantly improve the position
of the consumer. Mr O'Brien of Nottingham University Business
School told us that "the principles of financial management
that companies will be issuing earlier next year will help, but
even so my view is that with-profits will still be an act of faith
and that you are not going to be able to understand exactly what
has gone on."[14]
Several witnesses suggested that more fundamental reform might
well be appropriate. Mr O'Brien told us "the benefits of
with-profits can now be met by different means to avoid the situation
where we have lots of discretion and lack of transparency, so
I think there are now products in the financial markets that firms
can invest in that can actually deliver smoothing on a more mechanical
basis than we currently have with with-profits."[15]
This view was endorsed by Mr Sandler, who told us that "I
think, generally speaking, there are few investment needs which
are addressed by a with-profits policy which cannot better, more
cheaply and with greater flexibility be addressed by a combination
of other investment products."[16]
Many of the basic problems identified in endowment mortgages
are shared by other with-profits products sold by the life insurance
industry. The Committee is concerned by evidence that even after
the FSA's proposed reforms, buying any with-profits policy will
still be little more than an "act of faith" for the
consumer. Developing cheaper, more transparent products offering
the same smoothing benefits to the saver as the traditional with-profits
product is now a key challenge for the long-term savings industry.

14. Legal & General have described the endowment
mortgage product as "the child of generous tax breaks"[17]
and, as Mr O'Brien, one of our expert witnesses, noted, the on-going
growth of endowment mortgages after the product's tax advantages
began to be withdrawn in 1984 appears to have been simply a "bandwagon
that continued [rolling]."[18]
It seems likely that the tax system played a key role in encouraging
the growth of endowment mortgages relative to repayment mortgages.
The Sandler Review noted that tax complexity can "weaken
competitive forces by distracting attention away from the real
economic costs and benefits of different productscharges
and performanceand by making comparison between different
products more difficult."[19]
This view is shared by some of the major players in the financial
services industry. Mr Bloomer, Chief Executive of Prudential plc,
told us "I would much prefer a simpler [tax] system which
makes it much more transparent and easier for customers to see
where they are saving."[20]
It seems clear that it was undesirable for the tax system to
be so slanted as to entice consumers into one relatively complicated
financial product rather than a broadly comparable, but much simpler,
product such as a repayment mortgage. The Committee believes that
this is an important lesson for the future and strongly endorses
Mr Sandler's call that "the overriding policy goal in this
area should be one of reducing complexity and distortions
in the taxation of savings products".[21]

16. The period in which endowment mortgage sales
collapsed also coincided with intense regulatory activity on a
variety of fronts. Looking at potential investment returns, the
investment landscape had changed fundamentally through the 1990s.
Base rates fell from 14% in late 1990 to levels that were less
than half that through most of the mid-1990s. The risk free rate
of return expressed by long-bond yields, widely used as a benchmark
in gauging likely returns across a range of financial assets,
had also fallen from 11.8% at the end of 1990 to just over 7%
at the end of 1997, before falling below 6% in 1998. It was against
this background that the PIA embarked in October 1998 on a formal
consultation exercise on the need to reduce the illustrative investment
returns used in marketing material. They were subsequently reduced
from 5%, 7.5% and 10% to 4%, 6% and 8% in July 1999.[25]

17. The industry's slow switch to a more realistic
internal assessment of the likely investment returns underpinning
endowment products as the investment environment changed through
the 1990s may have reflected a desire to maintain the apparent
competitiveness of endowment mortgages relative to repayment mortgages.
The industry's failure to respond quickly to the sharp fall in
bond yields and inflation rates nevertheless raises significant
questions about the effectiveness with which the appointed actuaries
within insurance companies fulfilled their roles. Legal &
General, for example, told us that throughout this period the
appointed actuary had not issued a warning about likely investment
returns"not formally, informally or in any other way"[26]
and the evidence the Committee heard from other major insurance
companies[27] confirmed
that the appointed actuaries had generally failed to provide the
warnings that might have been expected about the changing investment
climate. As well as providing an earlier alert to everyone of
the potential problems building on endowment mortgages, if the
actuaries had raised such warnings on investment returns in a
more timely fashion the industry may have entered the bear market
in equities from 2000 onwards with rather more robust investment
portfolios.

18. The FSA has launched a major reform of the actuarial
function within life insurance companies, prompted partly by the
events surrounding Equitable Life. The evidence the Committee
has heard about the role the actuarial profession played, or failed
to play, in advising companies and their customers on the unfolding
problems in endowment mortgages confirms the urgent need for change.
The FSA's proposals, contained in consultation paper CP167 "include
discontinuing the role currently fulfilled by the appointed actuary.
Responsibility for actuarial aspects of the insurance business
would then clearly rest with the board and senior management,
rather than the appointed actuary."[28]
A new actuarial role is also being introduced for with-profits
business, in the shape of a with-profits actuary who will be barred
from sitting on the board and "will play an important continuous
role in protecting consumers."[29]
In addition the FSA is also requiring auditors to seek independent
actuarial advice, but the issue of the appropriate role for actuarial
advice is an important one which the Committee intends to return
to later in the course of our broad inquiry into restoring confidence
in long-term savings. The events surrounding Equitable Life
raised questions about the effectiveness of the pre-existing actuarial
regime, but the insurance industry's approach to endowment mortgages
through the late 1990s also demonstrates an inadequate approach
to investment issues by appointed actuaries. The Committee considers
it important that the FSA's proposed reforms of the actuarial
process within insurance companies are effective in providing
warnings and a more proactive and independently minded actuarial
advice.